One attractive feature of a fixed-rate mortgage is security: Because the interest rate is locked in for the life of the loan, the amount you pay each month in principal and interest will never go up. However, your monthly mortgage payment may still increase because the typical monthly mortgage payment consists of more than principal and interest.
A fixed-rate mortgage payment may rise for a number of reasons. These can include fluctuations in your current insurance premiums, as well as changes to the property tax rate in your area of residence.
The Basics of Taking PITI
The typical monthly mortgage payment has four elements, referred to by the acronym PITI: principal, interest, taxes and insurance. Principal is the money you borrowed; with each payment, you pay off a portion of the principal. Interest is the money you pay to your mortgage lender for the privilege of using its money for 15 or 30 years.
Taxes are the property taxes you pay on your home, and insurance is your homeowners' insurance premiums. In some cases, such as for borrowers with a small down payment or bad credit, insurance also includes mortgage insurance, which pays the lender in case the borrower defaults on the loan.
Understanding the Escrow Process
People new to homeownership commonly ask why their lender is collecting property taxes and insurance premiums rather than their local government or their insurance agent. Lenders do it because they want to protect their investment. As long as your mortgage is outstanding, your lender is as much an owner of your home as you are, and the lender wants to make sure its investment is protected.
Ensuring that the home is properly insured against calamity and that the tax man is properly paid gives the lender that protection. Your lender collects a portion of your annual tax and insurance costs each month. It sets the money aside in a special account -- called escrow -- and then pays the bills on your behalf when they arrive.
When Costs Rise
Property taxes and homeowners insurance premiums tend to rise over time. Lenders perform an "escrow analysis" once a year to see whether the money you're paying into escrow is enough or too much to cover your bills. During analysis, the lender recalculates the taxes and insurance portion of your monthly mortgage payment to cover any shortfalls and ensure there will be enough money in escrow to pay future bills. It's after escrow analysis that you might see your fixed-rate mortgage payment go up.
Getting Out of Escrow
Your lender may not require you to handle taxes and insurance through escrow. If you pay those bills directly, then your fixed-rate mortgage payment shouldn't have reason to change for the duration of the loan. Some lenders, though, require escrow. This is an excellent topic to discuss with your mortgage lender before you enter into any form of extended contractual borrowing.
Whether it's required or not, many homeowners appreciate not only the convenience of having someone else deal with the hassle of paying taxes and insurance, but also the ability to spread these large expenses over 12 months rather than having to come up with the whole amount each year.